Mittwoch, 26. September 2012

No two businesses are completely alike. Human resources make the difference. This leads to problems when applying multiple approaches to valuing businesses, whether small or big. Furthermore, for small businesses - "A small business is not a little big business", WELSH and WHITE, 1981 - the capital market is utmost imperfect. For this reason the several variations of the DCF approach are not convincing for the purpose of valuing entrepreneurial businesses. So an alternative approach to valuing entrepreneurial businesses is necessary. Such an alternative is the Functional Valuation theory:

The success of a new business mainly depends on two factors: the uniqueness of the business model and the ability of the entrepreneur to properly turn this idea into reality. However, it is also because of these two factors that entrepreneurial initiatives almost always go together with certain challenges. On the one hand, due to the singularity of the business concept, there are no experience values on which one can draw upon when appraising a new venture’s strengths and weaknesses. Moreover, since there is no data history at all, or just a very short one, the forecast of a young company’s turnovers and profits turns out to be an extremely demanding task. On the other hand, it is often the case that although the entrepreneur does have the technical skills to develop the product or service he has in mind, he lacks the required funds (Olbrich, 2002; Hering and Olbrich, 2002), business experience, and/or network to put his ideas into reality. Furthermore, entrepreneurial firms act in the environment of a highly imperfect capital market. This means in particular that debit and credit rates are unequal, the market participants’ ability to raise capital is limited and their tax burdens and information levels differ (Dixon, 1991; Hering, 2000; Brösel and Matschke, 2004) [...]

Valuation plays an important role in venture financing. For instance, when shares are issued to business angels or when an IPO is prepared, the parties involved have to determine the minimum/maximum price they have to demand/are able to pay if they do not want to change their initial wealth position for the worse. However, due to the capital market imperfections as well as the high degree of uncertainty, valuation models have to fulfil multiple requirements [...]

BRÖSEL, MATSCHKE and OLBRICH present an approach to valuation which
feature a technique sophisticated enough to fulfil these requirements:

In their article, ‘Valuation of entrepreneurial businesses’, Brösel, Matschke and Olbrich describe the functional theory of company valuation as an alternative approach to valuation. First of all, the authors work out the characteristics of small businesses and show that traditional methods like multiples, DCF, and real option approaches cannot handle the specifics of those valuation objects adequately. With the future earnings method and the state marginal price model, Brösel, Matschke and Olbrich then present two tools to derive the decision value of the entrepreneur. On this occasion, they also consider the problem of uncertainty and come to the conclusion that the way DCF methods process risk is flawed in many respects, while a Monte Carlo simulation leads to better results, in particular because such simulations show the complete range of possible outcomes of the decision value [...]

Valuation of entrepreneurial businesses

Abstract: "A small business is not a little big business" (Welsh and White, 1981) - this also holds true for valuing small businesses. Such companies act in utmost imperfect markets, are generally unique and the forecast of their future profit is rather difficult. These characteristics impede the use of DCF and real option methods, as well as of multiples. Therefore, this paper presents the functional valuation theory as an alternative approach to valuation. Its partial and general models allow a better adaption to the characteristics of entrepreneurial businesses, especially when these models are combined with a Monte Carlo simulation.

Freitag, 14. September 2012

In keeping with this week's theme of revisiting ghosts of valuations
past, I decided to take a look at another fallen angel, Groupon. The
stock has collapsed to $4.44 from its post-IPO high of $29 and investors and employees
seem to be fleeing from the exits. If you are a contrarian with a
strong stomach, it would like the stars are aligned for some bottom
fishing but is Groupon a buy, even at this discounted price?

To make this assessment, I decided to take a look at my posts on Groupon from last year:

In my very first post on Groupon
in June 2011, I looked at their attempt to move customer acquisition
costs from the operating expense to capital expenditures column. While I
was sympathetic to the general argument that operating expenses that
create benefits over many years (such as R&D, exploration costs and
even customer acquisition expenses) should be treated as capital
expenditures, I was skeptical in Groupon's case since there was little
evidence that Groupon's acquired customers stayed on for long periods
and also because Groupon did not follow through fully and treat
customers as assets (and amortize or depreciate these assets over
time).

In my second post in
October 2011, I looked at Groupon (as well as Google and Green
Mountain) with an eye towards potential growth, using four tests: the
feasibility of the growth given the overall market served by each
company, the capacity to scale up growth (i.e., maintain growth as the
companies get bigger), the value created by that growth and the effect
of management credibility on how the market perceives that growth.

In my third post on November 2, 2011, I valued Groupon
at the time of the acquisition. Using "aggressive" assumptions on
revenue growth (50% annually for first 5 years, scaling down to mature
growth by year 10) and pre-tax operating margin (23%), I estimated a
value of $14.62 per share, below the $16-$20 range that investment
bankers were touting.

The stock did go public on November 3, 2011, at $20/share, and jumped to $28 by the end of the day. My fourth post on Groupon,
on November 4, 2011, looked at the company in the context of a
discussion of the value of growth. For growth to add value, I argued
that it has to be accompanied by "excess returns", which, in turn,
require competitive advantages or barriers to entry. Looking at
Groupon's business model, I could not think of any significant barriers
to competition that would prevent others from entering the market and
eating away at Groupon's margins. Using a simulation, I estimated the
following distribution for value/share for Groupon in November 2011 and
argued that the stock was more likely to be worth less than $10/share
than it was to be be worth $30:

A year later, it is clear that I under estimated how quickly any
competitive advantages that Groupon's first mover status gave them would
be eroded. This is clear not only from perusing my email box every
morning (and removing the dozen emails from different deal-of-the-day
purveyors) but also in Groupon's financial results. As the most recent
earnings report makes clear, revenue growth has slowed, profitability
has lagged and the stock price collapse is in reaction these changes.

As
I revisited my valuation, as with Facebook, I had to caution myself not
to overreact, but the news, as I see it, is far more dire for Groupon
than it is for Facebook. While Facebook's results were disappointing in
terms of converting potential to profits quickly, the potential (from
their vast user base and the information they have on these users) still
remains. In Groupon's case, where the business model was clearer at the
time of the IPO, the business model has collapsed and it is difficult
to see what the company can do to set itself apart from the competition
and make money at the same time. As a result, the changes I made in my
Groupon valuation are more dramatic than the changes I made in my
Facebook valuation. My base year numbers reflect their most recent
quarterly filing, with trailing 12-month revenues of $1.965 billion and
operating income of $71 million. My forecasted revenue growth rate is
25% (leading to revenues in 2022 of $10.3 billion, as contrasted with my
earlier forecast of $25.4 billion), my target margin is 12% (down from
my year-ago estimate of 23%) and my sales/capital ratio is now down to
1.25 (from a year-ago estimate of 2.00). The end result is a value per
share of $4.07, which makes the stock, at best, a fairly priced stock.
In fact, if you bring in the likelihood that the firm may not make it
through its growth pains in the spreadsheet, the value per share drops
even further. As with the Facebook valuation, you can download my spreadsheet and put your own estimates in... I have a shared Google spreadsheet for those of you who want to share your numbers...

There are two broader point that are worth making here.

A dramatic stock price drop is not always a buying opportunity:
Most young growth stocks are subject to gyrations and it is not
uncommon to see growth stocks plummet, when they don't meet the lofty
expectations that investors have for them, and we have seen this happen
to both Facebook and Groupon. In some cases, investors over react and
push the price down far more than they should and that is the basis for my pitch I made for friending Facebook
in my last post. In some cases, though, the stock price collapse is
well-deserved and that is my rationale for avoiding Groupon.

Intrinsic valuations can (and should) change over time:
There is deeply held belief, at least in some quarters, that intrinsic
valuations are stable and don't change over time. While that may be true
in many companies and most time periods, there are three exceptions.
The first is a dramatic change in the macro environment. My intrinsic
valuations for almost all companies changed between August 2008 and
October 2008, as the market price of risk (in the form of equity risk
premiums and default spreads) increased dramatically in the aftermath of
the banking crisis. The second is when accounting fraud is uncovered
and key numbers have to be restated. The third is with young growth
companies where the premise on which the value of growth is based - that
it is scalable, defensible and valuable - is called into question. It
is the third exception that applies to Groupon and I feel comfortable
lowering the value per share from $14.82 a year ago to $4.07 today.